Globalization and Government PolicyRemarks at the Fifth Annual Federal Reserve Bank of Philadelphia Policy Forum

Most of you are probably familiar
with the mock epitaph offered by W. C. Fields, a native
of the City of Brotherly Love, who suggested his tombstone
read, “On the whole, I’d rather be in Philadelphia.” Well,
I for one am delighted to be both alive and in Philadelphia
today. I thank Tony Santomero and the Philadelphia Fed
for inviting me to join so many distinguished scholars
and analysts in contemplating the challenges posed by
the federal government’s budget deficits.

I wish George Shultz could
be here. I’m sure
many of you know him—or of him, at least. He is
a distinguished economist and public servant, who inside
and outside government has been an advocate for fiscal
sanity for decades. Shultz is now at Stanford University’s
Hoover Institution. I spoke with him a few weeks ago
and, sure enough, our conversation turned to one of
his biggest concerns: our burgeoning structural fiscal
deficits. He told me a story I want to share with you.
When he was President Nixon’s budget director,
Shultz became increasingly worried about the inability
of Congress to cut spending. Sitting in his office at
2 in the morning, he turned to his venerable aide, Sam
Cohen, and asked, “Sam, is there really any difference
between Republicans and Democrats when it comes to spending?” After
giving it some thought, Cohen replied, “They both
spend money. The only difference is that Democrats
enjoy it more.”

It is no longer clear who
enjoys it more, but it is crystal clear we need
to have a little less enjoyment
and a lot more fiscal rectitude. Today’s speakers
have presented facts and figures showing what will happen
if America does not change course. The economists who
preceded me today gave a thorough accounting of our
fiscal problems—all pretty grim. I have little
to add to the message. I agree that the longer-term
deficit projections are daunting, even if they do not
present a clear and present danger to an expansion now
entering its fifth year. I am, like many others here
today, deeply concerned about the magnitude of deficits
projected 20, 30 and 40 years into the future. Left
unchecked, they will become a grave danger to our prosperity
and run the risk of seriously undermining the progress
we have made in taming inflation. That said, I believe
the discussion of America’s fiscal deficits is
not complete unless we take into account the forces
of globalization.

How globalization impacts
the U.S. economy in general, and monetary policy
in particular, has become our focus
at the Dallas Fed. We believe that new technologies
and market-opening policies are changing the economic
environment—not only for the men and women who
run America’s businesses but for policymakers
as well. We are not yet sure of globalization’s
precise impact on the economy’s gearing, but we
are fairly certain that the old econometric models,
with their assumptions about output gaps, capacity
restraints and money flows, are no longer the best
guides for policy.
At the Dallas Fed, we are trying to better understand
how this country can succeed in a global economy.

Thus far, we have done a better job of raising questions
than providing answers. I suspect I will do a bit of
the same today. I also want to issue the standard disclaimer
that I, like Tony Santomero and the other Reserve Bank
presidents, speak only for myself and for no one else
on the Federal Open Market Committee.

Economic Policy in a Global Economy

Globalization describes
the economic reality of our times. In simplest
terms, it means a nation’s
economic potential is no longer defined by political
and geographical boundaries. Indispensable to the concept
is factor mobility. The globalizing world we live in
is one in which the goods, services, capital, labor
and ideas that propel economic growth are increasingly
free to migrate to where they are most valued and can
work together most efficiently, flexibly and securely.
These key factors of production avoid bureaucratic restrictions
that lock them into outmoded methods and organizations
and intrusive governments that limit their ability to
adapt to a rapidly changing economic environment. They
look for maximum profitability in returns on capital
and the lowest tax burden on the sweat of the brow.
In short, they constantly search for the environment
with the fewest obstacles to success and—this
is a point we must always remember—they are increasingly
free to move to more welcoming environments.

Economic policies, of course, can have a big influence
on decisions about where it is best to do business.
A globalizing world means governments, national as well
as regional and local jurisdictions, are forced to compete
to attract and to hold these increasingly mobile factors
of production.

U.S. business leaders have come to grips with the
inevitability of global competition. Now, our policymakers
must prove they can do the same.

I think monetary authorities around the world have
gotten the message. They have achieved a new discipline,
thanks in part to the competition created by globalization.
Open financial markets allow investors to seek countries
with stable money and shun those places where the value
of their capital will be eroded. A clear result of globalization
has been inflation rates converging at lower levels
in North America, Asia and Europe. When it comes to
accommodating inflation, central bankers everywhere
have become, to quote my late, great father-in-law,
Congressman Jim Collins, tighter than a new pair of
shoes.

Has globalization brought
a similar disciplining force to fiscal policy?
It is hard for me to stand here today,
among eminent scholars who delivered chapter and
verse on America’s fiscal profligacy, and tell
you we are seeing better fiscal policies. Yet,
I believe that
globalization is having a beneficial impact on fiscal
decisionmaking and that, while the United States
is hardly virtuous on this front in an absolute
sense, it is in better shape than most of its competitors.

Let me first turn to the discipline imposed on fiscal
policy by global forces.

Take taxes. In a world
where capital moves across borders more freely
than ever, globalization heightens
tax competition among nations, just as it does among
states in this country. Indeed, we are seeing the
average tax rate come down in the world’s most open economies
as nations compete for productive resources. Among OECD
nations, the average top corporate tax rate fell from
38 percent in 1996 to 31 percent in 2002. Estonia has
instituted a flat tax. Japan has learned through painful
experience what it means to raise taxes. Poland and
Germany are in the midst of tectonic political battles
in which tax issues loom large. And China rarely, if
ever, actually collects significant taxes from the corporate
sector. In today’s world, I doubt you can earn
many brownie points, let alone raise more revenues,
by increasing taxes on investors who are free to
roam.

One would think that globalization
would lead to similar discipline on the spending
side. In theory, increasingly
mobile companies and workers should not be fooled
by a government that promises ever-growing spending
not
paid for by existing or new revenue streams. They
should anticipate corrective measures down the
road and adjust
their behavior accordingly—at least if the theory
of rational expectations has merit.

When people fully understand
the economic environment in which policy is
being made—that is, when they
are rational—policymakers’ power to manipulate
the business cycle for short-term political gain is
mitigated. In theory, fiscal authorities who face rational
economic agents should find they can’t use deficit
spending to stimulate GDP because people will simply
save more in response to today’s increased public
debt, anticipating tomorrow’s higher tax bills.

But the deficit-reducing pressures anticipated by
theory have yet to arrive in reality.

The United States continues
to be a preferred destination for foreign capital,
the most mobile of factors. These
flows of international savings have made it easier—or
at least less painful—to finance our deficits
at low interest rates. Without capital from overseas,
the growth of government spending might have crowded
out the growth of household spending. Readily available
foreign money has helped finance our surge in consumption
spending and housing investment.

Why is this? I will offer one suggestion, drawing
on my past experience as a market operator and putting
on my old hat as an asset allocator: Other potential
destinations for significant investment are actually
doing worse than we are in terms of fiscal policy.

OECD data, which cover
state and local governments as well as national
budgets, show our public sector
in the red at a projected 3.7 percent of GDP this
year. In contrast, Japan is at 6.5 percent, Italy
at 4.3 percent
and Germany at 3.9 percent. France is only marginally
better at 3.2 percent, according to the OECD. The
assumptions behind these numbers may be a bit
dodgy: For example,
it is not clear whether the OECD data capture the
impact strong U.S. growth is having this year
on the federal
deficit and on state and local revenues. A similar
revenue swing is clearly not occurring in the
budgets of the
lander and central government in Germany, or in France.
French Finance Minister Thierry Breton’s straightforward
revelations just a few days ago make it clear that his
country’s fiscal predicament is far worse than
previously reported.

Here is the point: In terms of investors looking to
allocate their capital, and the impact they have on
the price of money, you cannot think of U.S. fiscal
policies in strict isolation from what is happening
in other countries.

Our long-term fiscal prospects
may be daunting, but we do not suffer from the
economic sclerosis that afflicts
the Japanese and the major European powers. Looking
longer term—to the structural problems of Social
Security and health care programs—we also must
recognize that we do not face the grim demographic challenge
posed by Japan’s aging population. Or Germany’s.
In the title of the recent German best-seller Das
Methusalem-Komplott,
even the language-challenged will catch the reference
to the Biblical Methuselah. Before the Latinization
of Florida, some of us used to jokingly call the state
God’s antechamber, a reference to its aging population.
Perhaps the title now better suits Japan or the European
lineup of Germany, France and Italy.

Syndicated columnist Scott
Burns and Boston University Professor Laurence
Kotlikoff describe the demographic
challenge in catchy terms in their thought-provoking
book, The Coming Generational Storm. They divide
the nations of the world into four quadrants
defined by
two dimensions—life expectancy and birthrate.
One quadrant is occupied by the major European economies,
Japan and China, all of which share the characteristic
of a long life expectancy and low birthrate. This group
they label the “Decrepit Quarter.” Another,
defined by low birthrate and short life expectancy,
is morosely labeled “Postmodern Malthusian Hell.” It
is occupied almost exclusively by Russia and other former
Soviet states. The United States inhabits the quadrant
Burns and Kotlikoff call the “Panglossian Balance.” In
their view, we teeter on “the tattered edge of
Panglossian balance,” with a population replacement
rate that is dangerously close to being insufficient
but still better than Europe’s, Japan’s
and China’s and free of Russia’s unique
pathology.

From an investor’s viewpoint,
one might reasonably assume that Panglossian Balance
trumps the Decrepit
Quarter and Postmodern Malthusian Hell—to say
nothing of the fourth quadrant, occupied by high-birthrate,
low life-expectancy Africa and labeled “Traditional
Malthusian Hell.” So does a more tolerant attitude
toward immigration and a culture that encourages
risk taking, enforces the rule of law and exhibits
ever-evolving flexibility and adaptability to competition.
We cannot,
moreover, ignore the reinforcement investors derive
from steady noninflationary growth. A few days ago,
we received revised numbers for third-quarter GDP—an
annualized gain of 4.3 percent. Take that 4.3 percent
and apply it to an economy that produces $11.7 trillion
a year and you get a little more than $500 billion
in growth. Think about that: In a year, the U.S.
economy grows in an increment only slightly less
than Russia’s
total GDP, measured in dollar terms. Or 31 percent
of China’s total output, 25 percent of France’s,
19 percent of Germany’s, 11 percent of Japan’s.
In one year! So we do offer investors the attraction
of significant growth, together with a less-threatening
demographic profile.

Compared with other nations, we look fairly handsome,
or at least less ugly. That said, being better than
the worst is cold comfort. Pursuing least-bad policies
carries tremendous risk. We can never be sure our advantages
will last, particularly if deficit spending erodes economic
performance or our politicians embrace protectionism
or other policies that might cause mobile factors to
flee.

It always comes back to
globalization. A world of porous borders, for
example, increases the ability of
younger citizens to escape the taxes foisted upon
them by the elderly. The young aren’t handcuffed to
the old—at wage-earner-to-pensioner ratios of
10 to 1, 3 to 1, or whatever the demographic profile
might be. Why should the productive, mobile youth
of the 21st century, cyberpowered from birth and
at home
in an interconnected world, stay and subject themselves
to high Social Security taxes when they can move
somewhere else and keep much more of their pay?

Globalization makes it harder to sustain a Social
Security system based upon intergenerational transfers.
It exposes much more rapidly and acutely the inherent
limits of such policies. If our fiscal authorities were
to take this and other real world verities into account,
it might just encourage better policies. And putting
our fiscal house in order before our competitors
do would further enhance our edge as an investment destination,
securing the future of successive generations of Americans.

The Monetary Temptation

At face value, fiscal policy
may not seem a concern for the Federal Reserve.
Taxing and spending, after
all, are not the Fed’s business. Congress holds
the power of the purse. But the Fed cannot be an
indifferent bystander to the overall thrust of fiscal
policy. The
reason is straightforward: Bad fiscal policy creates
pressure for bad monetary policy.

When fiscal policy gets out of whack, monetary authorities
face pressures to monetize the debt, a cardinal sin
in my mind. I do not believe the Fed or any other responsible
central bank has total leeway to monetize deficits in
a globalized world anyway.

In the foreign capital
flows that support our consumption, we have recently
seen the bright side of what globalization
means for monetary policy. We learned in Economics
101 that deficits exert an upward push on real
interest rates by crowding the market for available
funds.
This
theoretical pressure, however, has been mitigated
in today’s globalized economy, where we have had
little trouble tapping foreign savings to meet our domestic
needs. Capital has been “crowding in” to
our growing, noninflationary and stable economy.
The crowding-out issue might reassert itself over
the next
few years, however, as resurgent business investment
begins to compete with spending by households and
government. The prospect looms larger if other economies
provide
more attractive environments for investment capital.

In a closed economy, the
Federal Reserve might face political pressure
to keep interest rates from rising,
with an eye toward accommodating fiscal stimulus.
Or if fiscal imbalances were to balloon—to, say,
the dimensions forecast by many of this conference’s
participants—there could be pressure to deliberately
trigger inflation and thereby reduce the real value
of the public debt. Doing so would fuel inflation. In
an open economy, however, the situation is different.
When capital is free to move at the click of a computer
mouse or the close of an inventory cycle, we cannot
accommodate political pressures even if we were so disposed—which
we are not—because of the added risk of capital
flight to destinations where the purchasing power
of capital is better preserved.

It is the duty of the Fed to refrain from the slightest
temptation to monetize deficits or embrace any other
inflationary policy. In the Volcker and Greenspan eras,
the Fed has done quite well in this regard, and it can
be expected to continue countering inflationary pressures
should they arise.

Some of you may recall
that we gave in to the temptation to monetize
fiscal imprudence in the 1970s. The cure
imposed by the FOMC under Paul Volcker’s leadership
was bitter and painful for the nation. Since then, monetary
policy has been resolute. It is important to bear in
mind that the world is also a different place than it
was in the 1970s. We have seen the adoption of the euro,
the rise of China and India, advances in technology
that fuel factor mobility and dramatic changes in economic
opportunities in what was then the Third World. All
these forces give us less leeway to operate in isolation.
In today’s world, we have no option but to extend
the Volcker–Greenspan legacy of sound monetary
policy.

I think a city ordinance
requires that all speakers taking a podium in
Philadelphia quote Benjamin Franklin.
This is easy for me because I always carry a few
words from Franklin as a reminder of my obligation
as an inflation
fighter. In 1748, when we were a society of farmers
and the crown was the colonies’ currency, Franklin
said, “He that kills a breeding sow destroys all
her offspring to the thousandth generation. He that
murders a crown”—a dollar—“destroys
all that it might have produced.”

This was true in the agrarian
world of Ben Franklin, and it holds as well in
the cyber, nano, bio interconnected
world of Ben Bernanke—though I, of course, speak
for neither of them. Coddling inflation by monetizing
deficits is not an option in a globalized world. It
would erode our currency’s value and undermine
our economy’s potential to grow and create jobs.
The solution to the problems laid out by the participants
in today’s conference rests squarely in the hands
of our politicians, not with the central bank.

About the Author

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.

The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.